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UK equities

Are we nearly there yet?

In December of last year an important document, produced by officials at the Bank of England, was published. In essence it confirmed that there would be no further ‘moving of the goalposts’ on UK banks’ capital adequacy ratios.

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In December of last year an important document, produced by officials at the Bank of England, was published. In essence it confirmed that there would be no further ‘moving of the goalposts’ on UK banks’ capital adequacy ratios. The report, in theory, should have ended nearly a decade of deep-rooted aversion to investing in banks.

Except very few UK investors noticed. Or, if they did, they weren’t convinced that a major hurdle in bank rehabilitation had finally been overcome, with the go-ahead to start rewarding shareholders again in the form of dividends.

Perhaps the wording in the document wasn’t explicit enough? Tucked away in a supplementary document to the Bank of England’s main 68-page Financial Stability Report, the positioning of this crucial diktat looked almost like an afterthought.

Or perhaps the subsequent collapse in bond yields, the result of many central banks adopting a negative interest rate policy, caused investors to abandon fundamental research, swept away by the tide of gloom about financials ever facing a more benign operating environment?

In order to understand the present, let’s step back into the past.

The stretched loans to deposit ratio, which forced Northern Rock to rely on the wholesale funding market, ultimately leading to its failure, showed how lax the banking system had become before the global financial crisis.

For the US sub-prime crisis to bring down the fifth largest mortgage lender in the UK underlined the fragility of the banking model on a global scale. The reason was simple enough, although the solution harder. Banks didn’t hold enough capital relative to the size of their deposits, nor did they hold sufficient liquidity.

The response by the banking regulatory authorities was immediate. Banks needed to increase massively their capital adequacy ratios (CAR). But all sorts of questions remained. For a start, what sort of capital should banks hold in their crucial Tier 1 ratio? The answer to that was good old-fashioned equity, as defined by the Core Equity Tier 1 (CET1) ratio.

But what percentage of capital relative to their risk weighted assets was deemed adequate? Should sovereign bonds receive a risk weighting when calculating the crucial CET1 ratio? But weren’t Greek bonds, which yielded over 44%[1] during the 2012 eurozone crisis, indicating the likelihood of a country default, also sovereign? Ever since the financial crisis banks demanded clarity over the precise make-up of the CAR and for years the regulator didn’t provide it.

Crucially, regulatory uncertainty about the final amount of capital they wanted banks to hold was all-pervasive. An official figure would be stated, but then a speech or interview by an individual central banker or policy-maker would suggest that person would far prefer a higher number. No wonder investors were suspicious and disbelieving of official regulatory pronouncements.

No wonder, then, that December’s document was dismissed as unlikely to represent the end of the journey to higher capital ratios. The goalposts were bound to move again.

Fast forward to the recent dividend announcement from Lloyds Bank. After years of building up their capital requirements, Lloyds’s full year CET1 ratio equalled 13.3%. That compared to just 5.6% at the time of the Northern Rock failure and comfortably in excess of the 12% CET1 ratio as laid down in the supplement to the Financial Stability Report.

In order to reward investor loyalty Lloyds decided to pay both an ordinary dividend for 2015, totalling 2.25p per share (£1.61bn) and a special dividend of 0.5pence per share (£357mn), bringing the ratio back down to the required 13%.

But, and here is the crucial point, in order to do that, the bank had to seek regulatory approval. In other words the banking regulator gave its blessing to a reduction in its capital ratio – in favour of shareholders.

So, the child’s question from the back seat of the car. Are we nearly there yet – in terms of adequately capitalised banks?

The answer for me is simple. Yes, I believe we most certainly are.

The US 10 year bond yield plotted against the pan European banks sector index: bank watchers need to turn their attentions to fundamentals rather than be fixated by bond yields:

Source: Bloomberg – May 2015 to June 2016

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